Posts Tagged ‘passive activity’

It matters for real estate operators. The proposed regulations on the Obamacare “Net Investment Income Tax” impose the 3.8% levy on rental income, but not for “material participants” in a rental “trade or business.” Tax Analysts reports ($link) that IRS attorney David Kirk weasels out of saying what “trade or business” means:

“On one end of the [section 469(c)(7)] spectrum, you have the real estate pro that owns one-tenth of lower Manhattan and lives, breathes, and dies by occupancy, building up, renting out,” Kirk said, adding that that individual would be considered to be in the trade or business of renting real estate.

Kirk declined to say whether someone on the other end of the spectrum — the real estate broker who not only lists houses but also owns a couple of townhouses or condos — would be considered to be in the trade or business of renting real estate. “I’m not really comfortable coming out and saying what a trade or business is,” he said.

The term “trade or business” has been defined some under Section 108(a)(1)(D), which allows taxpayers to exclude debt cancellation income if the debt was on “trade or business” real property. The IRS discussed the issue in PLR 9840026 (some citations omitted):

The rental of even a single property may constitute a trade or business under various provisions of the Code. However, the ownership and rental of property does not always constitute a trade or business. The issue of whether the rental of property is a trade or business of a taxpayer is ultimately one of fact in which the scope of a taxpayer’s activities, either personally or through agents, in connection with the property, are so extensive as to rise to the stature of a trade or business. Bauer v. United States, 168 F. Supp. 539, 541 (Ct. Cl. 1958); Schwarcz v. Commissioner, 24 T.C. 733 (1955); See Higgins v. Commissioner, 312 U.S. 212 (1941) (management of taxpayer’s own investment portfolio not a business).

In Rev. Rul. 73-522, 1973-2 C.B. 226, the Service held that rental of real property under a “net lease” does not render the lessor engaged in a trade or business with respect to such property for purposes of section 871 of the Code

It was unwise to make “trade or business” status key to this tax; it makes it difficult for taxpayers to know whether it applies and it encourages taxpayers to be agressive. They should just say that if you achieve non-passive treatment as a real estate professional, you don’t pay the tax.

The tax law “passive activity” rules were written to shut down real estate shelters by making rental losses “passive,” deductible only to the extent of “passive” income. About 3 seconds after the rules were enacted, taxpayers began thinking of ways to generate passive income so they could deduct their passive losses by renting land or by renting property to a controlled business activity. Rules treating “land rent” or “self-rental” net income as non-passive were issued quickly to stop that.

The new Obamacare 3.8% tax on “investment income” will apply to “passive income” as determined under the passive loss rules, so a Tax Court decision issued yesterday exploring these issues takes on added importance.

The taxpayer leased land with cell-phone towers to his wholly-owned S corporation. The S corporation in turn leased the towers to phone companies. The taxpayer also leased land to his S corporation.

The S corporation mistakenly reported the income from its leases to the phone companies as ordinary income, rather than rental income, lumping the tower rental with the S corporation’s other business income. The taxpayer treated the income as non-passive.

The towers leased to the S corporation were reported as passive leases on the taxpayer’s 1040, as were the land rents. Some tower leases were profitable while others generated losses, but because they were all reported as “passive,” the losses and income offset.

The IRS had other ideas. The IRS left the K-1 income as non-passive, saying that the leases to the phone company wasn’t really “rental,” and in any case the taxpayer was stuck with the way the income was reported. The IRS split the income from “self-rental” of the towers to the controlled corporation, with the losses treated as passive and the income reclassified as non-passive under the self-rental rules. The bottom line: a lot of non-passive income that couldn’t be offset by the now non-deductible passive losses.

The Tax Court said the IRS was being too cute. The IRS said that the taxpayer was bound by his treatment of the S corporation tower income as non-passive because he had already grouped it with his other activities. Judge Halpern said the IRS regulations didn’t have to cause such a harsh result. While the taxpayer might be stuck with its return reporting for determining whether to report income from the K-1 as passive, that didn’t extend to the self-rental rules. so the taxpayer didn’t have to split up the cell-tower rental to the S corporation between profitable (non-passive) and loss-generating (passive):

We recognize that, because ICE erroneously reported all of its income as ordinary business (non-passive-activity) income, nonapplication of the self-rental rule of section 1.469-2(f)(6), Income Tax Regs., to ICE’s rental payments to petitioner, in effect, results in the reduction of what was reported as “active business income” and the offsetting creation of “passive income” in seeming contravention of the congressional conferees’ directive to issue regulations preventing that result. See H.R. Conf. Rept. No. 99-841 (Vol. II), at II-147 (1986), 1986-3 C.B. (Vol. 4) 1, 147. We do not believe, however, that ICE’s tax return mischaracterization of its tower access rental income from third parties should control the application of the self-rental rule where, as here, it is, by its terms, inapplicable, i.e., where petitioner’s towers were not, in fact, used in a trade or business. Moreover, we are not persuaded that the result we reach herein violates the conferees’ directive as it does not, in fact, permit “passive income” to offset “active business income”.

The Tax Court upheld the IRS in treating the land-rental as non-passive.

The Moral? The Tax Court reached a fair result, even though it had to stretch around the regulations to do so. Had the towers been rented to the S corporation for use in its non-passive business, the judge would probably have given the IRS its “heads I win, tails you lose” treatment — the income would have been non-passive, and the losses would have been passive and non-deductible. The result was different because the S corporation in turn leased the properties to third parties, instead of using them in its non-passive business.

The result is fair because the taxpayer isn’t really generating improper passive income that wouldn’t be there if it had reported the income on the K-1 properly in the first place.

This case reminds us how important it is to identify your passive activities and group them properly. With the 3.8% tax on passive income taking effect in January, this is even more important.

Last year a Tax Court decision implied an additional hurdle for taxpayers wanting to claim that they “materially participate” in an activity. A decision last week appears to have quietly removed this hurdle.
Net rental losses are normally “passive” unless you qualify as a “real estate professional.” Passive losses are deductible only to the extent of passive income. If you qualify as a real estate pro, then you can deduct rental losses if you “materially participate” in your real estate activities under the same participation tests that apply to other activities.
To be a real estate pro, you have to pass two tests:
– You have to participate more than 750 hours in a real estate trade or business, and
– Your real estate activities have to take more time than anything else you do.
A 2010 Tax Court decision said there was an additional test:

Because petitioners did not elect to aggregate their real estate rental activities, pursuant to section 469(c)(7)(A) petitioners must treat each of these interests in the rental real estate as if it were a separate activity. See sec. 469(c)(7)(A)(ii). Thus, Mrs. Bahas is required to establish that she worked for more than 750 hours each year with respect to each of the three rental properties.

At the time I argued that the last sentence was wrong — that the 750 hour test does not apply separately to each rental activity absent the “aggregation election.” A decision last week may indicate that the court has seen the light on this issue.
Last week’s case (discussed here) involved a taxpayer who had a day job that wasn’t in real estate, but that left him enough free time to do a lot of real estate work on his own properties. The Tax Court found that he was a qualifying real estate pro:

On the basis of the record and testimony provided at trial, we find that Mr. Miller has established that he spent more than 750 hours performing significant construction work as a contractor and on his rental real estate activities. We find that Mr. Miller spent more time on his construction work and rental properties than he did piloting vessels in the years at issue.
…
Mr. Miller completed a number of significant construction projects, both as a contractor and as a landlord, in the years at issue. He also performed a number of additional real estate tasks including researching properties, bidding on properties, finding tenants, collecting rent and performing maintenance work at rental properties. Mr. Miller presented contemporaneous work logs for his construction and rental activities and provided compelling testimony and witnesses. Thus, we find that Mr. Miller is a qualified real estate professional within the meaning of section 469(c)(7)(B)

.
The judge noted that Mr. Miller had not elected to “aggregate” his properties. Nowhere in the analysis of whether the taxpayer qualified does the judge consider whether he had to work 750 hours in each property to be able to count the rental hours towards the 750-hour minimum; in fact, he found that none of the properties reached the 750 hour requirements on their own.
I think that means the Tax Court has come around to my view. Sure, it would be nice if they would cite the Tax Update Blog in their decision (ahem!), but as long as they get the law right, that’s what matters.
Cite: Miller, T.C. Memo. 2011-219